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Traditional endowment policies no longer play a role in financing rented property. Since the decision of the Federal Minister of Finance to subject at least half of the income of all policies that have been completed or will be completed after January 1, 2005 to personal taxation, the popular tax-saving model has disappeared from the shelves of agents and agents.
This does not mean that lending insurances have gone out of fashion. Quite the opposite: the linking of loans and policies is still on the agenda. Only the sellers grab for some time to other products. At the moment, unit-linked annuity policies are the big hit. Behind it usually hide share savings plans, so that the private people speculate with borrowed money on the stock market. The opportunities and risks of the interest differential business are shown in the following example.
Property on a par with marriage savings
A 45-year-old lawyer who works in a large law firm and earns about 120,000 euros a year, wants to set up a marital tax-free model with her husband, a self-employed doctor. She wants to buy a property and rent the object as a practice room to her husband. So the couple wants to kill two birds with one stone. The monthly rents, which the physician has previously paid to “unloved” strangers, should remain in the family in the future, and the two freelancers hope to be able to improve the private pension with the system.
From the perspective of the lawyer, the business is the classic purchase of a real estate on the market. The object should cost about 530,000 euros, this amount includes all utilities. Of this total, four fifths can be written off with two percent annually, so that rents remain tax-free up to an annual amount of € 8,480. The monthly income is estimated at 2500 euros. Of this, after deduction of operating and maintenance costs, about 2,000 euros are left over. The practice will remain family-owned for 20 years because the doctor is almost 48 years old. After that, the property, so the freelancers hope to be sold for 500,000 euros. The annual return on practice is 4.5 percent before taxes. After the deduction of taxes, the lawyer will have an annual deficit of 3.1 percent.
From the point of view of the lawyer, the return should rise. This is not because of an attempt to drive up the rents or the terminal value, but because of the fact that the woman has to take out a mortgage. It has only 100,000 euros on the high edge, so that the house bank must contribute the open 400,000 euros in the form of a loan. That will not be a problem in the present case. The two investors are very popular with the bank, and the institution hopes for high-yield business.
Direct use of equity
The first opportunity to finance the property is the direct use of equity (100,000 euros) and the direct repayment of borrowed funds (400,000 euros). The debts are taken at a rate of 100 percent, the current nominal interest rate of three percent per year is fixed at ten years, then caution is expected with an annual interest rate of four percent. If the numbers are correct, the bank’s banker has to flip a total of 240 monthly installments of € 2433 each to be debt free after 20 years.
This leads to an annual effective interest rate of 3.3 percent before taxes. If the benefits arising from the deductibility of interest are included in the cash flow, costs will decrease to 1.9 percent. This leads to the bottom line to a real estate savings plan with interest rate leverage of 120 basis points: are used at the beginning exactly 100,000 euros, followed by 240 installments, which rise in the course of time from 535 to 979 euros, and in the end beckoned a credit of 500,000 euros and a Return of 4.5 percent after taxes.
Optimization through pension insurance
The interest on the savings contract can be influenced by the suspension of the repayment and the investment of the returns in equities. The basis of the attempt to optimize the return is a fixed loan. The equity is used in full, as in the classic annuity loan, so that another 430,000 euros from another side are necessary. The nominal interest rate in the first half is also three percent per annum, and in the second half a nominal interest rate of four percent applies. This leads to 120 interest rates of € 1075 and 120 follow-up rates of € 1433 each.
Added to this are the premiums for the investment contract. The insurance expects that the unit-linked pension policy will yield at least five percent per annum. There are no objections to this forecast, as stocks have paid off in the past at seven to eight percent per annum, so there is certainly the possibility of achieving at least five percent in the future. But the forecast is tricky if the annual asset management fees are swept under the carpet.
They are usually two percent, so the question arises as to what impact the one-time and ongoing costs have on the forecast. Does the annual return drop from five percent to three percent, or does the policy tacitly assume that the fund manager will beat equity markets by 40 percent for a total of 20 years because the asset manager will earn an annual interest rate of seven percent?
The fees of unit-linked capital insurance are tricky. In the forecasts of the companies usually “market successes” are assumed, and the costs are not considered. Instead, they are hidden in flowery words in the fine print, so that the investor in many cases overread the numbers.
Consequently, only the rule of thumb helps to deduct the costs from the forecast. Anyone who hopes to achieve an annual return of five percent on the international capital markets with equities of all kinds should, at a cost of two percent, correct “success” to three percent a year. Otherwise, the investor himself is fooling himself, and that would have serious consequences when it comes to financing.
With an annual interest rate of three percent, 240 premiums of 1312 euros each are necessary to reach a value of 430,000 euros after 20 years and to be able to repay the credit of the house bank in one sum. In addition, debts still have to be paid to the tax office. The benefit of the pension policy, the difference between the paid in 314,880 euros and the final balance of 430,000 euros, is taxable in half, so that the lawyer probably has to pay 23,000 euros to the Treasury.
The costs of the fund policy and the taxes of the contract result in connection with the fixed loan at an effective interest rate of 1.8 percent per year. This is a 10bp advantage over the annuity loan, so the benefit is hardly worth mentioning. It’s about 4000 euros, and with this amount, any reasonable investor will rightly ask why he should suspend the eradication and seek his luck on the stock market. With these numbers, the waiver of the repayment just does not pay off, because the diversion of the money in the fund policy yields too little.
The sober conclusion does not mean that investing in shares is not worthwhile. The whole thing just needs to be knit differently. Financing will be optimized if the loan is raised to € 530,000 and all equity is put into a stock index fund. This offers two advantages. First, the interest differential is fully utilized. In this case, this means that the higher interest rates – 120 times 1325 euros and 120 times 1767 euros – lead to higher advertising costs. In addition, the share savings plan reduces monthly installments because the annual cost is 50 basis points or less.
The one-time payment of € 100,000 leads to a final balance of € 241,000 with an annual interest rate of 4.5 percent. Of this, the investor is estimated to have € 204,000, because the difference in the form of withholding tax goes to the Treasury. Consequently, over the two decades, a further 326,000 euros must be purchased in order to pay off the loan in 20 years. For this 240 monthly installments of 939 Euro are necessary.
And yet speculated on credit
The combination of the high fixed loan and the low savings rates leads to an effective interest rate of 0.4 percent after tax. That means in plain language that the financing is almost for free. The distances to the second solution and to the first model climb to present values of 68,000 and 71,000 euros, so that the diversion of the eradication offers “noticeable” advantages. With these numbers, everything speaks for the third financing, because it provides the highest return. The only thing the lawyer has to realize is that there is nowhere to guarantee a forecast for equities to grow five percent annually in the future. The end value can deviate up and down.
In addition, further questions arise. This starts with the risk appetite of investors. The savings plan based on exchange-traded index funds offers present value benefits of 70,000 euros, but the contract should not obscure the fact that the freelancer speculates with a loan on the stock market. The shot can be a direct hit, but it can also be a shot in the opposite direction if the investor loses her head in heavy turbulence.
Why the whole?
Added to this is the question of what the practical nutritional value of unit-linked capital insurance is. When the freelancers choose stocks, they choose shares, so the packaging is expensive ballast. Therefore, if anything, only the solution in question: The one-time investment of 100,000 euros and the savings rates do not need a coat that costs two percent annually. This is cheaper with the help of exchange-traded index funds.
The thoughts are dominated by the consideration of why the lawyer and the doctor even want to plunge into this adventure. The third combination brings a return of 6.3 percent per year. The stock savings plan brings a return of 3.6 percent. Consequently, the bare savings contract “only” 85,000 euros more than the combination with real estate and credit. Of course, 85,000 euros are not a cardboard box, and the two freelancers may have professional or personal reasons why they want to buy the practice. But all investors who only want to invest money each month, should think twice, whether the whole effort with the property and the credit and the index fund is worthwhile. Is not the naked thrill on the stock market enough?
The author is a financial analyst in Reutlingen.
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